What is the IS-LM Model?

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money supply" (LM) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curves intersect to show the short-run equilibrium between interest rates and output.

Key Takeaways

  • The IS-LM model describes how aggregate markets for real goods and financial markets interact to balance the rate of interest and total output in the macroeconomy.
  • IS-LM was devised as a formal graphic representation of Keynesian economic theory.
  • IS-LM can be used to describe how changes in market preferences alter the equilibrium levels of GDP and market interest rates, but the model lacks the precision and realism to be a useful prescription tool for economic policy.

Understanding IS-LM Model

British economist John Hicks first introduced the IS-LM model in 1937, just one year after fellow British economist John Maynard Keynes published The General Theory of Employment, Interest, and Money. Hicks's model served as a formalized graphical representation of Keynes's theories, though it is used mainly as a heuristic device today.

The three critical exogenous – i.e. external – variables in the IS-LM model are liquidity, investment, and consumption. According to the theory, liquidity is determined by the size and velocity of the money supply. The levels of investing and consumption are determined by the marginal decisions of individual actors.

The IS-LM graph examines the relationship between output, or GDP, and interest rates. The entire economy is boiled down to just two markets, output and money, and their respective supply and demand characteristics push the economy towards an equilibrium point.

Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves, IS and LM. Gross domestic product (GDP), or (Y), is placed on the horizontal axis, increasing to the right. The interest rate, or (i or R), makes up the vertical axis. The IS curve depicts the set of all levels of interest rates and output (GDP) at which total investment (I) equals total saving (S). At lower interest rates investment is higher, which translates into more total output (GDP) so the IS curve slopes downward and to the right. The LM curve depicts the set of all levels of income (GDP) and interest rates at which money supply equals money (liquidity) demand. The LM curve slopes upward because higher levels of income (GDP) induce increased demand to hold money balances for transactions, which requires a higher interest rate to keep money supply and liquidity demand in equilibrium.

The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance. Multiple scenarios or points in time may be represented by adding additional IS and LM curves. In some versions of the graph, curves display limited convexity or concavity. Shifts in the position and shape of the IS and LM curves, representing changing preferences for liquidity, investment, and consumption, alter the equilibrium levels of income and interest rates.

Limitations of the IS-LM Model

Many economists, including many Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted model's flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later on, by something better." Subsequent revisions have taken place for so-called "new" or "optimized" IS-LM frameworks.

The model is a limited policy tool, as it cannot explain how tax or spending policies should be formulated with any specificity. This significantly limits its functional appeal. It has very little to say about inflation, rational expectations, or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and labor productivity.